Why Past Performance Isn't a Good Guide to Choosing ETFs

Investors in Schwab Intelligent Portfolios™ may wonder about the process for choosing the exchange-traded funds (ETFs) that go into the portfolios. Why not simply choose the top-performing ETFs?

One answer is simple: Because most ETFs are designed to track a particular index, their performance, by and large, isn't indicative of anything other than the performance of the ETF's underlying benchmark index. Choosing an ETF based on past performance is about as useful as deciding to buy a security simply because its price rose last year.

The question is understandable, though, particularly if you're familiar with the star ratings of independent research firm Morningstar®. The Morningstar Rating™ measures a fund's past performance against other funds in its category. If you're considering investing in an actively managed fund, past performance may be a useful measure of the fund manager's skill versus his or her peers.

However, ETFs are rarely actively managed—and while there are some actively managed ETFs, Schwab Intelligent Portfolios doesn't use them. Most ETFs are designed to mimic the performance of a particular benchmark, such as a stock or bond index. Keep in mind that while indexes have no costs because they aren't actually managed or investable, ETFs incur day-to-day costs including operating expense ratios (OERs).

Historical returns aren't predictive. Certain ETFs may focus on areas of the market that have done especially well in recent years, but that doesn't mean those areas will continue to outperform in the future. Chasing ETF performance is like trying to time the market—a strategy that typically doesn't pay off.

So, if past performance is a poor guide, what's a better answer? Schwab Intelligent Portfolios starts with these three steps:

Identify the right peer group. ETFs are a useful way to gain exposure to particular segments of the market, both broad and narrow. There's an ETF that tracks the largest U.S. companies by market capitalization, and there are ETFs for much smaller market segments. Some ETFs track traditional market capitalization-weighted indexes such as the S&P 500® Index; others track fundamentally weighted indexes, which select and weight their components based on objective financial measures such as sales, cash flow or dividends. Schwab Intelligent Portfolios chooses ETFs in various asset class categories, and uses a blend of both market cap-weighted and fundamentally weighted ETFs for the major classes.

Eliminate any ETFs that don't meet minimum standards. Even ETFs that track the same benchmark are not identical. Some have a history of tracking their benchmarks more closely than others. Not all ETFs are easy to trade, a factor often reflected in an ETF's bid-ask spread.1 Others haven't been operating long enough to adequately establish a track record, or have such low investor demand that they're in danger of closing. When considering ETFs in any category, Schwab Intelligent Portfolios first eliminates those with relatively high tracking error (that is, they don't track their benchmarks as well as other ETFs), those with wide bid-ask spreads, and those with insufficient history or investor demand.

Look for ETFs with low expenses. Generally, an investor can expect to pay more for an ETF that is narrowly focused on a specific country, industry, or unconventional index, because trading in smaller or less-liquid markets can be more costly. It wouldn't be fair to compare the expense ratio of an ETF benchmarked to an unusual asset class with one that tracks, say, large-cap U.S. stocks. However, it's perfectly fair to consider the expense ratios of ETFs within the same category. All else being equal, Schwab Intelligent Portfolios' selection process favors those ETFs with the lowest expense ratios in each asset class. And over time, lower expense ratios may help performance.

Once ETFs are selected for Schwab Intelligent Portfolios, they are monitored periodically to make sure they remain an appropriate choice for the portfolios. Read more about the ETF selection process here.

1. Bid-ask spread reflects the best price at which someone is willing to buy a security, or the "bid," versus the best price at which someone else is willing to sell it, or the "ask."

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Investing involves risk including possible loss of principal. Past performance is no guarantee of future results.

Investment returns on ETFs will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.